What is meant by
the money
supply? The term itself implies that a certain amount
of
money exists at any given time, even though the quantity may be
unknown.
In truth there can be no meaningful measure of the quantity because it
is
continually varying as a function of demand.

The Fed has
its own arbitrary measures of
the money supply which it once used to help guide its monetary policy
decisions. It defines money as the total of cash in circulation
and
deposit liabilities of banks and thrifts. At one time it set
targets for
the growth of the money supply. Now it largely ignores its own
measures
because it has found little correlation between them and its major
policy
objectives – limiting inflation and unemployment.

Monetary Aggregates

The Fed has defined
three monetary aggregates M1, M2, and M3. The narrowest
definition, M1,
includes the transaction deposits of banks and cash in
circulation. M2
adds savings accounts, small time deposits at banks, and retail money
market
funds. M3 adds large time deposits, repurchase agreements,
Eurodollars,
and institutional money market funds. In March 2006 the Fed
discontinued
tracking M3 because it does not convey information about economic
activity that
is not already embodied in M2.

Note that the
Fed's definition of the money
supply includes only what the non-bank sector holds. Thus the
reserves of
banks, i.e. vault cash and deposits at the Fed, though a part of the
monetary
base, are not included in the monetary aggregates. That means
when a bank
spends for itself, it increases the money supply. When it
receives
payments from the public such as interest on loans, the money supply
decreases.

Bank Lines of Credit as a
Money Equivalent

An important
shortcoming of the Fed's
definition is that it ignores lines of credit which can be exercised at
the discretion
of the borrower. Firms often hold substantial lines of credit
from their
banks, which they can use on short notice. Likewise consumers
hold lines
of credit in their credit card accounts that are just as useful for
purchases
as checking accounts or the currency in their wallets. Lines of
credit
increase liquidity, which is ultimately
what counts in terms of
enhancing aggregate demand.

When someone
uses a credit card in a
purchase, he automatically expands the money supply. The seller
receives
a new deposit in his account, which increases the total of demand
deposits in
the banking system -- until the buyer pays off the loan. The
result is that
consumers who roll over their credit card loans rather than paying them
off
have increased the money supply on their own initiative by hundreds of
billions
of dollars. In effect, the money supply is substantially larger
and less
measurable than the Fed's definition.

The Quantity Theory of Money

Economists
regularly use the term money supply
without defining it. A notable example is the equation of
exchange in the
quantity theory of money.

MV = PT

This relates
the money supply, M, and the
velocity of money, V, to the average price level, P, and the total
number of
transactions, T, in a given time period. The equation is simply
an identity,
meaning it is true by definition. Yet it is often used to
"prove" that the average price level increases with the quantity of
money. An identity says nothing about causal relations. The
only
thing we know is the product MV, which equals the national income, PT,
which
itself is only roughly measurable. The quantity of money, M,
remains
undefined and unknowable.